BI urged to divest its reserves to ease panic

JAKARTA (JP): Bank Indonesia, the central bank, should divest a significant amount of its foreign exchange assets to help desperate indebted firms and stop the fall of the rupiah, Australian economist Ross M. McLeod said.

McLeod suggested in his paper "On Causes and Cures for the Rupiah Crisis", published in the Bulletin of Indonesian Economic Studies' December edition, that Bank Indonesia (BI) publicly announce such a divestment of reserves to lessen public anxiety.

"The dramatic fall of the rupiah has been driven largely by panic, rather than careful analysis of Indonesia's economic fundamentals," McLeod said.

"What is now the appropriate course of action? Many observers argue that what is needed is a kind of psychological circuit breaker to turn market sentiment around.

"The announcement of an intention on the part of BI to divest itself of such a large volume of foreign exchange assets has the potential to become the circuit breaker needed to bring the rupiah crisis to an end," he added.

Indonesia appeared to have reserves of US$26 billion at present, he said. The official figure was over $20 billion. But on top of that, Indonesia still had $5 billion in foreign assets.

The reserves were too large for a country with a floating currency, McLeod said.

The ratio of Indonesia's reserves to the annual gross domestic product was now 15 percent, far higher than had been found workable in various other countries with floating exchange rates.

Australia, Canada, France, Japan and the United Kingdom, for instance, all had ratios of only 3 percent to 4 percent in 1995, McLeod said.

In those countries, rather than relying on the government to hold exchange rates steady, the financial markets developed means by which economic entities could cope with potential movements, such as forward, futures and options contracts in foreign exchange.

"The decision no longer to control the exchange rate by intervention in the foreign exchange market implies that there is now no need for BI to hold such a large volume of international reserves," he said.

By divesting its foreign exchange assets to indebted firms, at reasonable prices, BI could address one of the main causes of the crisis: unhedged private foreign borrowings.

If BI were to divest 80 percent of its foreign reserves, it would be sufficient to allow private borrowers to pay off almost half of their debts.

An announcement of the intention to offer for sale such a large volume of funds -- perhaps $500 million everyday for 40 days -- would have a significant impact on conditions in the market.

"The effect of such an announcement would be to suggest that any further large fall in the rupiah would be unlikely in the near future," McLeod said.

This move would also add to the pressure on many exporters, who still held back their export revenues in anticipation of further rupiah depreciation, to sell their dollar holdings to the market.

Importers presently bidding for dollars to meet their more distant requirements might also be persuaded to stay out of the market for the time being.

"To these effects could be added a reverse flow of portfolio capital in search of investment bargains, given the extent of falls in the rupiah price of shares, and the fall of the rupiah itself," McLeod said.

He said there was some similarity between what he proposed and the actions taken by the government in 1975 and 1976 to deal with the Pertamina crisis, in which the central bank used up almost all of its reserves to repay a large proportion of the state- owned oil firm's foreign debts.

"It is certainly not proposed that BI should take over any part of the private sector's debts," McLeod said.

Firms needing to purchase foreign currency to meet their foreign borrowing commitments would still suffer losses due to market rates remaining well above initial expectations.

"BI would simply be ameliorating these losses by adding greatly to the amount of foreign currency offered for sale in this crucial period," he said.

BI had received an enormous windfall gain of over Rp 30 trillion (US$5.9 billion) by virtue of devaluation of the rupiah over the last three months, much of which had been at the expense of companies that had borrowed offshore.

"It is difficult to see any justification for withholding $20 billion or so from the market when BI now really has little use for these funds," he said.

He said President Soeharto himself, in his last Independence Day address, had already moved toward the market's direction in terms of the exchange rate -- far in front of mainstream opinion.

"It remains to be seen, however, to what extent the government will be willing to call the speculators' bluff by selling off a substantial portion of its newly augmented reserves," McLeod said.

But the sales of reserves by BI had to be accompanied by a corresponding rundown in the quantity of Bank Indonesia Certificates (SBI), in order to avoid any significant tightening of liquidity, he said.

McLeod said the liquidity squeeze had failed to defend the rupiah. Instead, it had brought many economic activities, especially those of the modern sector, to a standstill.

He shared Indonesian economists' calls for the government to abandon such a useless policy.

He called on the government to seek an expansion to its spending to drive domestic economic activities rather than belt- tightening measures which would be counterproductive for the economy.

The government is currently preparing a state budget for the 1998/99 period which is likely to be smaller than previous years as it has targeted to reach a surplus of one percent of its gross domestic product.

"The cutback in government spending seems quite unnecessary. To the extent it is real, it will simply exacerbate the slowdown caused by reduced liquidity," McLeod said.

He also suggested that the government abandon its targeting on reducing the current account deficit. He contended that the logic of a floating rate regime was that the size of the current account deficit should be determined by the market.

The present sharp devaluation was the market's response to the sudden switch from surplus to deficit in the capital account, requiring an equal and opposite adjustment of the current account.

"The government's belief in the necessity of deliberate action to reduce the current account deficit, and its continuing use of high interest rates, indicate its reluctance truly to embrace market determination of the exchange rate: it has floated the rate, but it continues to look for other ways to control it indirectly.

"This continuing propensity to override the market is a fundamental obstacle to restoring the economy to good health," McLeod said. (rid)